SASB Speaks: What can Investors Learn from Emissions Data?

Beginning in the 1970s, regulators in the U.S. and Europe gradually implemented regulations targeting key air emissions, ranging from particulate matter to carbon dioxide. These substances not only harm the environment and human health, but can also impact the performance and shareholder value of truck manufacturers. The recent experience of the industry in the U.S. show that the risks and opportunities flowing from exhaust pipes demands investor attention.

The EPA makes a move
In early 2010, the U.S. Environmental Protection Agency (EPA) implemented a change in existing emissions regulations for heavy-duty diesel engines, the type found in long-haul highway trucks. The rules established emissions limits for Nitrogen Oxides (NOx), among other pollutants which affect ambient air quality.
At the time, a few companies lead by Cummins, Navistar, and Paccar with combined sales of nearly $36 billion, dominated the U.S. truck engine market. Navistar alone commanded 36 percent of the heavy duty on-road truck market in the U.S. and Canada, including Class 6, 7, and 8 trucks, which include most tractor-trailers, and school buses.
There are two prevailing technologies used to reduce NOx emissions. The first is called Selective Catalytic Reduction (SCR), and the second is called Exhaust Gas Recirculation (EGR). For the 2010 standards, most engine makers, Cummins and Paccar included, chose to employ a combined strategy of both EGR and SCR to meet the 2010 standards. Navistar, conversely, chose to pursue an EGR-only strategy on the premise that it would be a lower-cost alternative for customers. This decision would eventually have enormous consequences for the company and its investors.

Performance diverges
Importantly, emissions test results published deep in the EPAs databases showed a disparity in performance between the major engine manufacturers. In 2010, Cummins and Paccar achieved levels well below the limits of the new standard. Navistar’s results, however, remained stubbornly high, more than twice those of its competitors.
Nonetheless, Navistar was still able to sell its engines because of previously banked emissions credits. Additionally, the company could sell non-compliant engines if it paid a penalty of several thousand dollars per engine. The company continued to invest heavily in its EGR technology in order to meet regulatory requirements. In its Securities and Exchange Commission (SEC) disclosure, Navistar even began reporting its improvements in emissions performance, reiterating that its EGR technology would deliver. In its 2011 Form 10-K, the company stated, “We believe that coupling EGR with our other emission strategies will provide a significant competitive advantage over our competition’s products.”

Time runs out
Following a profitable 2011, the clock quickly ran out on Navistar. By early 2012, the company had few emissions credits remaining, EPA penalties and warranty expenses were on the rise, and its customers were losing confidence. On July 6, 2012, Navistar announced that it was reversing course and adopting the SCR technology used by its competitors. The company’s stock fell nearly 15% on the news, and the company’s CEO resigned a month later.

A combination of warranty claims, EPA non-conformance penalties, and plummeting market share combined to turn a $320 million GAAP pretax profit in FY 2011 to a $1.1 billion loss in FY 2012. As the full extent of the company’s financial troubles gradually unraveled, investors fled. Shares cratered from a high of nearly $70 in May 2011 to below $19 by October 2012. Over the same period, Navistar’s major competitors experienced revenue growth as they captured market share.

Investors left in the dark
With the benefit of hindsight, it is clear that Navistar’s approach to meeting the EPA’s new rules was risky. The intriguing question is whether investors could have found actionable, forward-looking information in publicly-reported emissions data.

Had the company and its peers reported emissions data in public filings, investors might have questioned Navistar’s approach earlier. They could have used the emissions data to hold management accountable and ask tough questions during earnings calls—questions such as, ‘what happens if the company can’t meet the EPA’s limits? How long will the company’s emissions credits last?’ However, an analysis of a sample of 2015 SEC filings shows that 50% of disclosure on this topic is boilerplate in nature. This is indicative of historical trends in disclosure, suggesting that investors lacked the information they needed to accurately assess risk.
The global automobile industry today finds itself facing similar pressure, as fuel economy and CO2 emissions regulations tighten. For example, Ford Motor Company is struggling to meet progressively more stringent EPA fuel economy and CO2 emissions limits for some of its vehicles, according to a recent report by Bloomberg. As many as 40 percent of F-150 models, the company’s most popular vehicles, do not meet 2016 standards. While the company can pay a penalty in order to sell vehicles that do not meet the standards, the CO2 standards are a requisite. Tougher standards in 2025 make the case all the more pressing for the company and for its competitors. Meanwhile, companies including Volkswagen AG, Suzuki Motor., and Mitsubishi Motors have admitted to falsifying fuel economy and emissions test results.
Investors examining long-term financial performance of their holdings should carefully consider product emissions performance. As a starter, calling for comparable disclosure of emissions data in financial filings as enabled by the SASB metrics for the Industrial Machinery industry could allow investors to incorporate regulatory risks and opportunities into their investment decisions and better compare performance between companies.